Market's New Worry: What If Fed Doesn't Cut Rates?

The markets are expecting a rate cut. The Federal Reserve is reluctant to give them one. Add to the mix some surprisingly good economic news.

What've you got? A lot of confusion.

As investors await Friday morning's report on August employment, there is a growing feeling in the markets that a Fed rate cut may not be such a sure thing after all.

"The employment data is going to be big this week," says Ben Lichtenstein, president of Tradersaudio.com. "It’s a missing piece of the puzzle. With all the speculation that’s out there, all the conflicting contributing factors--volatility is sure to continue."

The back and forth over a rate cut has roiled stocks in recent weeks and is likely to continue even after the report on non-farm payrolls is released at 8:30 am New York time. Economists are expecting an increase of around 100,000 jobs.

"The market has a rate cut baked in the cake," says Thomas Higgins, chief economist of Payden & Rygel Investment Management. "If the number comes in at 110,000 or above, the market will say 'It's old news.' But if it comes in below 100,000 they'll say, 'Well, look at this-- the Fed needs to cut.' The market will discount anything that doesn't support a cut as they did (Wednesday) with the Fed's beige book."

"No Investor Bailout"

As Fed Chairman Ben Bernanke made clear in a widely followed speech last Friday, the central bank is ready to cut rates if turmoil in financial markets starts spilling over to the general economy. But, Bernanke added, "it is not the responsibility of the Federal Reserve -- nor would it be appropriate -- to protect lenders and investors from the consequences of their financial decisions."

On Thursday, there were several positive economic reports, including stronger than expected August sales by retailers and continued growth in the services sector. Though stocks rallied on the news, it also heightened worries that the Fed may be on hold when policymakers meet Sept. 18.

So what if there's no rate cut? Most market pros believe it would not be a pretty sight for stocks--at least at first.

"I think initially the market would sell off and it could be a sharp one, " says Stephen Leeb, editor of the Complete Investor newsletter and president of Leeb Capital Management. "But the market would steady itself and investors would reason that the Fed decided not to cut because of strong evidence the economy is OK."

Dilemma for Markets

That's the dilemma: The markets want the economy to be weak enough to force a rate cut, but not enough to hurt corporate profits.

"The general consensus is that they are going to cut," says Tom Schrader, managing director of listed trading at Stifel Nicolaus. "But Wall Street needs to be careful what they wish for because if they cut it will mean things are a lot worse than people think."

Others agree that the Fed should stay on hold.

"Not only do I think they won't (lower rates), but i don't think they should," says Brian Wesbury, chief economist at First Trust Investors. "Chairman Bernanke really has a chance to solidify his credibility and his independence. Interest rate cuts aren't going to make any subprime mortgage holders whole, they're not going to help any of these asset backed securities."

Wesbury believes the present course of action by the Fed will work. "They’re doing the right thing. They’re opening the discount window in case there are major problems. They’re providing liquidity through open market operations. That’s what they can do."

And even those who expect a rate cut this month say it won't be a disaster if the Fed stands pat.

"If they don’t cut in September that doesn't mean they won't at a future date," says Leeb of Leeb Capital. "The Fed has made it clear they will protect the economy."